The Company You Keep, The Advice You Accept

“There are few regulations that smart, motivated targets cannot evade.”

— Vanguard founder Jack Bogle

Bogle may have said it more succinctly, but “The Market for Financial Adviser Misconduct,” a new working paper by three scholars from the University of Chicago and the University of Minnesota says it with an abundance of eye-opening, data-driven evidence … and with an intriguing twist, which we’ll cover in a moment.

First, the main point: Financial adviser misconduct remains alive and well … and as difficult as ever to regulate away. That means that it’s as important as ever to choose wisely and carefully whose financial advice you heed.

An Analysis of Adviser Misconduct

Beyond the headline-grabbing Bernie Madoffs in our industry, how much and what sort of misconduct is out there? Who is being most heavily impacted by it? What are we doing (or not doing) to eliminate it? The paper’s co-authors sought to answer these vital questions, describing their work as “the first large-scale study that documents the economy-wide extent of misconduct among financial advisers and financial advisory firms.”

[Financial] Firms that persistently engage in misconduct coexist with firms that have clean records. We show that differences in consumer sophistication may be partially responsible for this phenomenon: misconduct is concentrated in firms with retail customers and in counties with low education, elderly populations, and high incomes

Unfortunately, there’s no big surprise there. But back to that plot twist. One part of this groundbreaking study could be misunderstood at face value, and may cause some in my industry to shy away from talking about it at all. Not me! I want to take a deeper dive.

A Fascinating Plot Twist

Rightfully so, the study identified two types of financial advisers: (1) those who are registered as investment advisers, which obligates them to serve their clients’ highest financial interests … at least when dispensing that investment advice; and (2) those who are not.

Surprisingly, the study found that the first type – the investment advisers – were “50% more likely to be disciplined for misconduct than the average financial adviser.”

Wha … ??? Since I am so very proud to be an adviser who is committed to only and always serving my clients’ highest financial interests, I couldn’t help but cringe when it looked as if “my kind” may have fallen short in the findings. But then I noticed this critical detail in the disclosures: “Approximately half of active advisers are registered asboth brokers and investment advisers.”

That means that many in the study’s so-called investment adviser group were apparently serving two masters. They were partly sales representatives for their broker, bank or insurance agency. When they weren’t engaged in that role, then they were partly adviser to you, the investor. In industry lingo, this is known as being “dual registered.” In my lingo, it means conflicted interests and confusing sources of compensation.

To confirm our take on the study, we reached out to its authors – Mark Egan, Gregor Matvos and Amit Seru – for their feedback. Here are their thoughts on the matter (and many thanks to them for responding to our query):

“The focus of our study were all financial advisers registered with FINRA. Given that there are approximately 650,000 such advisers registered in the U.S. we think understanding misconduct in this market is of great importance for investors. Our study does not measure misconduct of single registered investment advisers, as you correctly point out. We are not aware of any systematic evidence documenting differences between ‘dual registered’ financial advisers, and those registered only as investment advisers. While it is certainly possible that single registered advisers have substantially lower levels of misconduct, we think systematic measurement is the only way to address whether this is indeed the case, and think that is an area with great research potential.”

We applaud the study’s authors for initiating this important conversation in an evidence-based manner. We also hope that this initial foray will invite the follow-up studies and additional inquiry they suggest, to take on these essential details. After all, that’s what robust academic inquiry is all about – continuously improving our understanding of the ways of the world.

Selling Products vs. Offering Advice

For now, whether it’s for financial planning, investing, or your overall wealth management, we recommend you pay close attention to how your “adviser” is actually earning his or her keep and whose interests he or she truly has in mind.

First, it’s a good idea to look for any adviser’s past misconduct by keeping an eye on his or her record in FINRA’s BrokerCheck database. On pages 56–57, Appendix A3, the Financial Adviser Misconduct study provides some excellent examples of what to look for there. If you’d like to look up my own BrokerCheck record, here’s the link.

Second, regardless of the job title, beware of those whose business models and financial incentives best position them to be SELLING YOU SUITABLE PRODUCTS, rather than SERVING YOU WITH TRUE, FIDUCIARY ADVICE.

On Ethics and Advice

Why does an adviser’s incentives matter if the end result – your money, invested in the market – seems the same either way? Here is a powerful blog post by Ramit Sethi on the subject of persuasive selling: “My favorite commercials.” (That darn gum commercial chokes me up every time!) As Sethi observes, “The truth is, we’re profoundly influenced by what we see and hear, including ads. This isn’t a bad thing. It doesn’t make us weak. It makes us human.”

So, it’s not that sales and advertising don’t have their roles in a free-market economy. But, because persuasion can play so heavily on our emotions, without our even being aware of it, we must all proceed with extreme caution in realms such as medical care, legal counsel, and, yes, financial advice. These are areas in which ANY advice given should be delivered strictly according to the recipient’s highest interests; where ethics MUST come ahead of profits; and where ALL of us should be doing all that we can to minimize conflicting incentives for investor and adviser alike. It’s important, because we’re all susceptible to incentives; we’re all human.

Whether in advertising or advising, we like Sethi’s description of appropriate ethics: “My simple ethical rule of thumb is this: ‘If someone were rational and had all the information and motivation in the world, would they want this product?’ If the answer is no, we shouldn’t try to persuade them. If the answer is yes, and we know our product can help, it’s actually our obligation to try to persuade them.”

THAT’S why it matters.

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